What are stock splits?

A stock split means that a company’s board of directors decides to increase outstanding shares. One share is divided into multiple shares during a stock split, and the stock price becomes less. However, this action does not have any impact on the company’s capitalization.

There are different kinds of stock splits. The most famous ones include the 2 for 1, 3 for 1, and 3 for 2. If this concept is too complex for you, we can use this analogy: let’s say that a kid comes to me and asks if I have two $5 bills to exchange for his $10 bill. He wants to buy ice cream, but he is the first customer, and the vendor does not have a change. Hence, he cannot sell to the kid. I agree to give my two- $5 bills for a single $10 bill because it does not change the value of my $10. This situation is very similar to a 2-for-1.

At least, in this case, there was nothing significant that happened. But in trading and investments, some companies do this for many various and substantial reasons. Read more to know why they do this.

Why do companies split their stocks?

In our ice cream example earlier, we said that splitting that $10 bill into two $5 bills does not make much difference in the value. While that is true, doing this in stocks and shares makes a lot of difference from people’s and investor’s perspectives. Companies have many reasons behind doing this. If they do, it is most likely because of psychology.

A stock with a massive price tends to scare most investors. Small investors think that this stock is way out of their league, while the regular and some big investors may believe that this stock is too expensive for them. In this case, companies feel like they need to do something that will make this stock look more attractive to most investors without compromising its value.

If a company does this, its stocks will be more interesting to investors, especially to the new ones. Since we are speaking of the psychological effects, we can also include the way the existing shareholders feel. Stock splits also make them feel that they have more shares than they did, but in reality, nothing changed. But if the price did increase, it means more tradable stocks for them.

Also, we cannot deny the fact that stock splits help in making stocks more liquid. A stock with a higher price per share will indeed have a more extensive bid-ask spread. So if the stock has more outstanding shares, it makes the stock more liquid.

Is it a beneficial move?

There is also a term called a “reverse stock split,” where a company decides to make multiple shares into a single one. Companies do this sometimes because they think that their share price is losing its worth. While some companies resort to this, others continue to see stock splits on a positive note. They say that if a company splits its stocks, its share price is fairing too well to the point that the company needs to split it. Some say that it might just be a strategy, but even if it is, most say it is pretty effective in enticing investors.